ATO confirms tax liability after death

The Australian Taxation Office has issued a new ruling that means spouses and children could face six-figure tax bills on the death of a parent or partner, while throwing estate planning arrangements into chaos.

The extra taxes must be paid on top of the 16.5 per cent death benefits tax in cases where the beneficiary is an adult child. The Tax Office is saying private pensions are no longer tax-free once the pensioner dies, which means that beneficiaries will be forced to pay capital gains and income tax on the assets of the deceased.

The draft ruling clarifies the tax treatment of pension assets following the death of a member.

Peter Burgess, technical director of the SMSF Professionals’ Assoc­iation of Australia, argued that the capital gains tax bill could be extremely large, particularly in cases where a fund had owned shares or property for many years.

“The tax bill could be very significant if there is a property in the fund because the property market has ­performed pretty well over time," Mr Burgess said.

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Macquarie Adviser Services executive director David Shirlow said: “If the assets have been held for a significant period, we may well be talking in the tens of thousands, if not hundreds of thousands, of dollars."

Advisers and accountants have been campaigning for several years for the ATO to rule that once a pensioner dies, their savings be left in the pension phase until all the assets are sold or transferred.

Under this scenario, the beneficiaries would not be subject to capital gains or income tax.

Although the ATO is inviting industry participants to comment on the draft ruling, Mr Burgess said last night he was not hopeful officials would entertain any significant changes.

“The National Tax Liaison Group [which is sponsored and chaired by the commissioner of taxation] has been discussing this for two years," he said.

“It is unlikely the ATO will change its mind."

Self-managed superannuation funds (SMSFs) are likely to be hit hardest by the ruling because their balances tend to be higher and do-it-yourself funds must dispose of assets to pay death benefits.

Large pooled funds might not need to sell off the assets to pay death benefits, so there would be no requirement to pay capital gains tax.

One expert said the ruling was “atodds with the way the industry operates".

Mr Burgess said many fund members were likely to be surprised by the changes, and Mr Shirlow said there would be “a lot of contention" over the ATO’s interpretation of the cessation of a pension.

The current rules are mired in confusion. Despite an interim decision by the ATO in 2004 that pensions be ceased once a member dies, many fund members are under the impression that, if they die, their assets will be passed on free of capital gains and income tax.

The new ruling clarifies the ATO’s position.

“A superannuation income stream ceases when there is no longer a member who is automatically entitled, or a dependent beneficiary of a member who is automatically entitled, to be paid a superannuation income benefit," the draft ruling says.

Under the new rules, the sale of any assets to pay death benefits will be subjected to 10 per cent capital gains tax, while any dividend income or interest earnings that flow into the fund will be subjected to 15 per cent income tax immediately upon the death of the member.

The new rules will hit adult children – who are also subject to the 16.5 per cent death levy – the hardest because they will have no choice but to pay the additional taxes.

“If you have no spouse or dependent child, you are exposed," said Mr Burgess.

A spouse or dependent child would be able to avoid paying the tax if the superannuation fund trust deed states that when a member dies, their assets can be distributed in the form of a pension, rather than as a lump sum payment.

This strategy would not attract capital gains tax because no assets would need to be sold to fund the pension payments.

However, if the trust deed makes no provision for such pension payments, the assets that are attributed to the deceased member must be taken out of the pension.

In many cases an actuary will be required to determine which assets belong to the deceased.

The surviving spouse may be able to recontribute the assets into another pension, but they would be subject to strict contributions caps.

A surviving spouse who is over the age of 65 would not be able to contribute the money if they failed to meet the so-called work test.

This means they must be gainfully employed for a minimum of 40 hours in no more than 30 consecutive days in the tax year in which the contribution is made.

The new rules are set to throw estate planning arrangements into chaos. For example, couples who wish to avoid paying capital gains and earnings tax on their assets will be forced to pay their death benefits as pension rather than a lump sum to the estate.

Mr Burgess said this would anger people who did not wish to hand over complete control of their assets to a spouse.

He said fund members would also need to make sure that when their fund moved into the pension phase, the trust deed was amended to make provision for a pension to be paid to a spouse or dependent child.

“You need to make sure the trust deed allows a reversionary pension nomination," said Mr Burgess.

When the final ruling is issued, it is proposed to apply from July 1, 2007.

Mr Burgess said the ATO’s position was that the draft ruling was merely clarifying the rules, even though many estates were being managed under different rules.

Advisers were disappointed with the ATO’s stance. They argued that pensions should be allowed to maintain tax-free status after a member died.

Under the superannuation rules, death benefits must be paid as soon as is practical, although there is no strict deadline.